The fiscal coin and reasonable expectations: Taxes as business costs or intra-economy transfers?

Are taxes on corporations business costs or intra-economy transfers? This is a oft-discussed question in debates about corporation taxes – academic, political as well as layman debates. And it is one with significant implications for tax policy.

This blog is here to say: Both. Possibly. But mostly a transfer.

The fiscal coin and taxes as intra-economy transfers

Every so often, we’ll hear the argument that taxes are business costs. Simple as that. They reduce corporate profits by increasing expenditure. And the implications are straightforward: If taxes are merely costs, there is an imperative to minimise the cost, thus maximising profit, in order to generate value for shareholders and stakeholders, including society at large.

This view, however, neglects – deliberately or as an indirect consequence – the fiscal coin. A favourite concept of mine, which receives far too little attention, the fiscal coin is the equal and opposite mechanisms of taxing and spending. As a matter of economic reality, any tax must translate to an exactly equal expenditure or saving, and any spending must be based on an exactly equal tax (current or future). Taxes do not disappear into a black hole; they pays for something. We may not like how they are spent, but we cannot deny that they are indeed spent (or saved).

Thus, whether or not businesses perceive tax as merely a cost, it is, as a matter of economic substance, an intra-economy transfer. From corporate books to somewhere. And businesses act accordingly.

My old microeconomics textbook noted in its introductory chapter that, in the same way that pool players operate as if they were familiar with the basic laws of physics, economic agents act as if they are familiar with the basic laws of economics. I’m skeptical toward this as a universal assertion, but in this case I do believe it provides a helpful image.

Businesses do act as if they know that taxes are intra-economy transfers (at least to some extent). In making investment decisions based on the availability of local infrastructure, skilled workers, low political risk premiums, and so forth, there is a recognition that taxes, while they may be an initial cost, boost factors that ultimately contribute to profits. And indeed, there are many businesses that openly acknowledge this relationship, certainly in Denmark where tax norms are perhaps special.

Reasonable expectations and taxes as business costs

So, taxes are intra-economy transfers. But, there is an entirely plausible argument that taxes may in fact also be just business costs, although it is not the one often purported. It has to do with reasonable expectations.

If businesses have a reasonable expectation that corporation taxes, on average or on the margins, will not contribute to profits in any way, we can say there is a fair argument that corporation taxes are just business costs. If taxes do not contribute to local infrastructure, to skilled workers, to low risk premiums or to any such element, then there may be a point.

And while I am doubtful that assertion can be evidenced, the perception of such a situation may explain why the view of “tax as a pure cost” is prevalent.

Why might this perception emerge? I shall highlight two potential causes. First, businesses may reasonable expect that the overall tax burden and the associated level and content of public expenditure is not determined to any relevant extent by corporation tax payments. This view may in fact be reasonably substantiated given the structure and trend of overall tax revenues in developed countries over the past few decades. As corporation tax rates have steadily declined, many states have shifted tax burdens away from capital and towards individual income, consumption or property. In fact, this is the exact recommendation that the European Commission, along with the OECD, has been providing to member states over the past few years. So there may be a reasonable expectation from businesses that any reduction in corporation taxes, whether through avoidance/evasion or through tax incentives, rate cuts or base narrowing, would be countered by the state with a burden shift to other taxpayers, thus maintaining the overall level of public expenditure and thus profit-boosting institutions.

Second, businesses may reasonably expect that their marginal contribution to the overall tax burden has a non-existing or insignificant effect on any beneficial (for them) public spending. They may simply not perceive there to be a quid pro quo. This is the classic ‘tragedy of the commons’. Barriers to collective action will mean that businesses will seek to free ride. This goes for all taxpayers, but large, multinational companines in particular have a significantly greater ability to free ride, to selectively determine tax level and location, than the average taxpayer. In an age of declining societal tax morale due to increasing perceptions of injustices in the tax system, this may well be a phenomenon on the rise. Moreover, the general opacity of the tax-to-spend dynamic may worsen the dynamic. Politicians are largely skeptical towards earmarked public funding, and thus it is impossible to establish a specific link between the tax that businesses (or other taxpayers) pay and the associated spending. Finally, societal disinclination towards tax may also contribute: a general skepticism to taxation may mean taxpayers are less positive towards the fiscal coin.

Political implications

Thus, corporation taxes are, in substance, intra-economy transfers. But as a matter of perception and maybe reality, they may also be merely business costs. The political implications are crucial, I believe.

Whether or not corporation taxes – and indeed other taxes – are perceived as bearing effectively on taxpayers’ benefits deriving from public spending is essential to fiscal policy. If they are not, that is a major policy problem, both for the tax and for the spending system, and something that needs to be addressed by governments. Most definitively, we need to strengthen tax morale by ensuring tax compliance across the board. Perhaps we also need more transparency around the way in which average and marginal tax payments contribute to public spending and welfare benefits. More generally, perhaps we need a broader and more vocal discussion on the link between tax and spending. That is certainly a debate worth having…

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[…] literature. Even though taxes also pay for public spending (the fiscal coin), there may be a reasonable expectation by wealthy taxpayers that any evasion on their part will not lead to a deterioration in public […]